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Project finance for renewable energy
Renewable Energy, Vol.5, Part I, pp. 700-708, 1994
Elsevier Science Ltd Printed in Great Britain 0960-1481/94 $7.00+0.00
Pergamon
PROJECT FINANCE FOR RENEWABLE ENERGY S J Mills, Director Sceptre Management Limited, UK and Melissa Taylor, Consultant ABSTRACT This paper is intended to provide general advice to sponsors of renewable energy projects who expect to raise project-based financing from commercial banks to fund the development of their projects. It will set out, for the benefit of such sponsors, how bankers typically approach the analysis of these undertakings and in particular the risk areas on which they concentrate. By doing so it should assist sponsors to maximise their prospects of raising bank finance. The watchword for sponsors approaching banks must be "Be Prepared". KEYWORDS Finance, Bankers, Risk Analysis, Annual Debt Service Cover Rario.
Before going further however we should define the term "project finance". Many definitions exist but what most lending bankers generally mean by the term is: 'the financing of a project or other asset or undertaking which is repaid principally from the cash flow generated by the project or asset being financed'
Typically the lending banker will have little or no recourse to any other assets or cashflows of the project sponsor. Hence the alternative descriptions - "limited- (or non-) recourse financing" or "off-balance-sheet financing". We should also ask why project sponsors may wish to use project finance for the financing of renewable energy developments. There are a number of different potential reasons. Firstly, isolating the project in this way may mean the corporate sponsor can avoid showing the debt on its balance sheet. Secondly, where corporate capital is limited and must be rationed among competing projects, limited-recourse project financing may provide a means of increasing the debt element of a project's funding. Assuming the project is successful this will have the effect of increasing the return on equity invested in the project. Thirdly, in a project invoMng more than one sponsor where a joint venture structure has to be adopted, project financing may be an attractive option. Where one party is financially stronger than its partner such a party may seek project finance for the whole project to ensure the weaker partner has access to sufficient funds for its share of costs. Fourthly, a sponsor may have the conscious aim of laying off or at least limiting specific risks. Last but certainly not least, for the smaller sponsor project financing may be the only source of finance available. This list is certainly not exhaustive, but it may help to clarify the typical motivations of project sponsors in seeking project financing. Needless to say the categories mentioned above are not exclusive either - a single sponsor may be pursuing several of the above objectives at the same time. Having defined our terms and understood the sponsor's likely reasons for seeking project financing we can now turn to the banker's attitude to this type of funding. When approached with a project financing opportunity the lender will usually seek to address three key areas: 700
701 'are the economics of the project bankable?' 'what are the project risks, are these risks acceptable and if not how can they be mitigated or allocated to acceptable third parties?' 'is it worth the effort to try to answer the first two questions and put together an acceptable deal structure?'
This last factor is of critical importance, especially for the smaller renewable energy entrepreneur seeking to arrange project finance for the first time. Winning the Banker's Attention
Because of the importance of the third question these three areas will be looked at in reverse order. Many projects never make it past the first discussion with potential lenders and, once a lender has said 'no', it is extremely difficult, if not imposs~le, to resurrect real interest. The reason for the lender turning down a particular deal may be justifiable. The project may not be viable from an economic perspective. However many potential sponsors may have met with comments from bankers such as: 'the sponsor is too small compared with the size of the project' 'the technology risk is unacceptable' as a first comment from a potential lender before he states that he does not wish to pursue the opportunity. The sponsor may feel that the lender has completed no more than a cursory review of the project and has not explored the ways in which such risks or problems could be mitigated or allocated to third parties. The sponsor may well be correct. In such circumstances one may never know how closely the potential lender has analysed the financing opportunity or indeed the real reasons why he is not interested in the proposal. The point is that the sponsor should "Be Prepared" by understanding the major factors which drive a banker's thinking and attitudes. We would like to draw out three separate issues which may influence a banker's views -especially in today's banking market - before he even undertakes a detailed evaluation of a potential renewable energy project. Firstly, it is useful for project sponsors to understand the current state of the world banking markets. Many banks have experienced major losses as a result of the Third World Debt Crisis and US secondary banking market problems, and more recently from the effects of the world recession on their clients. These events have resulted in a weakening of banks' capital ratios which -to complicate the problem further - have now to be maintained at minimum levels under the Basle Convention. The banks have two options if they are to maintain capital ratios either to raise more capital, which may not be a real option, or to reduce their asset bases by a reduction in lending. Project finance is a specialist, higher-risk area of banking often with large capital requirements. One result of the problems in the world banking markets has been a reduction in the number of banks willing to provide project finance. How can project sponsors react to such developments? First of all, they should target their approaches to those remaining project financing banks which have retained the lending capacity to support the capital-intensive industries. Secondly they should, wherever poss~le,
702
draw upon any existing relationships which they may have with banks and seek to capitalise upon them. In times of capital stringency banks will tend to support their existing clients, sometimes even to the detriment of sound projects proposed by non-customer sponsors. We shall have more to say about the banker's attitude to the identity and standing of project sponsors shortly. The second issue here is the failure of many sponsors to understand the fundamental approach a banker must take in terms of his "risk-reward" relationship with a project. The lender's recourse is limited to the Project's assets and cashflows. If it performs badly he may lose the whole of his principal, let alone the interest due to him. As such he may be said to have "maximum downside". If the project outperforms all expectations the lender can (usually) hope to do no better than to receive his principal back plus the agreed interest payments. Thus he has little or no "upside" potential. Given such a risk-reward balance a provider of bank finance will probably be most concerned to limit risla Although he may be indirectly interested in the Internal Rates of Return potentially available from the project he will be much more concerned to establish that the project will be able to service its debt, with a good margin of cover, under a wide range of adverse scenarios. Put in these terms the issue may seem obvious, but in our experience sponsors frequently fail to approach a potential lender with an information package which demonstrates an understanding of his likely concerns and attempts to address these concerns in a manner which makes his analysis easy to carry out. Meeting the lender on his own ground and satisfying him that he is not taking an undue measure of risk is a critical component of "Being Prepared". The third aspect of a banker's general attitude is the question of project size. Sponsors should be aware that the smaller the project and associated debt requirement the more difficult it is likely to be to raise finance. In today's market where the active project lenders are being asked to look at more projects, the earnings potential from a $100 million project loan will usually ensure that it takes precedence over a $10 million potential facility as they will both require broadly similar amounts of time to review, structure and document. Clearly if a sponsor has a $10 million project there is little he can do about its size, and this should not be taken as saying that smaller projects cannot be financed - project-based debt finance has been raised for projects costing less than $2 million. The point is, however, that a sponsor seeking finance for a smaller project should anticipate the "size" objection and should consider before approaching potential lenders whether he is prepared to offer the lender a level of return - eg by way of higher front-end fees - which though expensive from the sponsor's viewpoint does at least ensure that the project does not fall at the first financing "fence". Again - "Be Prepared". Risk
Analysis
and Allocation
Assuming that the sponsor has successfully negotiated the first hurdle and convinced the banker that a full analysis of the project should be undertaken, the next stage will usually be for the banker to carry out a review of the major risk areas of the project. These areas of risk vary from project to project but we will concentrate briefly on seven key areas of risk. T h e s e are; - Sponsor Risk - Technology Risk - Completion Risk - Input / Supply Risk - Operating Risk
703 Approvals / Environmental Risk Offtake / Sales Risk Sponsor and completion risks are closely associated as a lender's view on completion risk will be strongly influenced by his view on sponsor risk. Sponsor risk is extremely important and recent discussions with project lending banks suggest that it is becoming more rather than less important in the current market. Indeed one European bank recently commented that: 'our preliminary review of a project is increasingly sponsor-driven'. What then is meant by sponsor risk? Banks take an interest in the sponsor of a project on two levels. A lender will normally require a capital contribution of anything from 15%-50% of the project cost to ensure the sponsor's continued commitment. Banks are interested in project sponsors on another level however. Regardless of whether the lender is seeking pre-completion guarantees from the sponsor (which we shall discuss later) banks predictably like to work with corporate sponsors with substantial technical expertise and financial "depth". The 'backstop' value to a bank of a sponsor who can commit resources either financial or technical to turning around a problematic project is very great. Therefore entrepreneur sponsors of renewable energy projects - who will often not have the same corporate "substance" as major companies should anticipate and prepare for a discussion with potential lenders on this issue. The attitude of potential lenders towards sponsor risk is a key factor in steering many sponsors towards inviting a more substantial sponsor to enter into a joint venture arrangement. This will usually have the effect of reducing sponsor risk in the eyes of a potential lender. Smaller sponsors should not assume however that it will be a waste of time to approach bankers before the support of a more substantial partner has been negotiated. On the contrary - if the original sponsor is aware in detail of the type and extent of support the banker will require from the equity investor(s) in a project he will be in a much stronger position when negotiating the terms of any joint venture with a new partner. Moving on to completion risk, banks are willing in certain circumstances to assume precompletion risk for projects. By this we mean that they may be prepared for their lending to be limited in recourse to the project itself before completion occurs. Acceptance of precompletion risk is by no means the norm however. Often banks will require some kind of external recourse until completion, such as a guarantee from third parties such as the owners of a project-owning joint venture company. Entrepreneur sponsors in particular should therefore be prepared for lender concern on the issue of pre-completion risk as they will usually not be able to offer blanket guarantees of such risks which would be acceptable to the lender. It is an important component of being prepared that the sponsor should have analysed the pre-completion risk issues likely to be raised by potential debt providers and should be in a position to demonstrate: a)
that the pre-completion risks involved are modest, and/or
b)
that everything possible has been done to mitigate these risks and/or to lay them off elsewhere.
It is very important for sponsors to understand what is meant by 'financial completion' as opposed to 'physical completion' in terms of what risks sponsors may be asked to assume. For financial completion to be demonstrated, not only will the project facilities have to be acceptably completed but operation will have to be sustained at a pre-agreed level of output, with availability figures and operating costs also meeting pre-agreed targets over a specified
704 period. Essentially a sponsor providing a completion guarantee may well be assuming a number of other project risks. For example a project in production and operating satisfactorily may never achieve completion due to not achieving cost forecasts. The lender will focus upon the cost-overrun and time-delay aspects of the completion risk in great detail. This is the period of highest risk for the lender. The lender may face a total writeoff in respect of a project which never produces cash flow. The lender will seek to minimise this risk by looking at such aspects as whether high-value items can be built under fixed-price turnkey contracts. He will also analyse whether the various contractors are financially sound and whether their obligations are covered by performance bonds or third party sureties. It may be poss~le subject to the robustness of the project economics to pre-agree a debt-funded cost overrun contingency facility, or indeed to raise additional equity up-front. Banks can be expected to pay a great deal of attention to the question of technology risk in renewable energy projects. As we explained earlier, because of their risk-reward relationship with a project bankers are keen to limit risk and in particular they will always seek to avoid accepting risks which should properly be taken by the equity owners in the project. Any technology which is at the "leading edge" of current practice will certainly be placed in this category. As a technology becomes more established using other funding sources banks may become comfortable with the predictability of the processes involved and begin to accept the technology risk. Some banks have already completed this process for technologies such as wind turbines and landfill gas. Even for technologies such as these, however, project sponsors should be prepared for a detailed examination of the technology risk issue by potential debt-providers and should seek in their initial paper to demonstrate:
a) b) c) d) e)
that the technology has a satisfactory track-record; that the contractor building the project has experience of the technology; the adequacy of the guarantees / warranties which have been negotiated; the ease with which maintenance and, if necessary, component replacement can be carried out; that the availability / efficiency levels predicted can be easily achieved.
By input / supply risk is meant the risk relating to provision of the relevant source of energy to the project in question, such as methane-bearing gas in a landfill project, wind energy for a windfarm, chicken litter in a waste-burning power station and so on. Where there is a distinct (and finite) "reservoir" of fuel for a project - such as in a closed landfill - bankers will look for an independent corroboration of the sponsor's reserve figures by a first-class consultant appointed by the Bank and paid for by the sponsor. Given the risk-reward relationship the banker has with the project he will typically wish to concentrate on any "core" reserves which have the highest degree of certainty and to have his debt repaid well within the predicted economic life of these reserves. Even where there is no reserve factor to be considered project sponsors should, when approaching potential financiers, be prepared to demonstrate the security of fuel supply arrangements, including the basis of pricing of the fuel. The sponsor's presentation should show that the assumptions made relating to the quantities and pricing of fuel are conservative and that even on this basis the proposed debt can be retired with a significant margin of safety. It is likely that a lender will wish to take security over any fuel supply contracts and this factor should be borne in mind by sponsors when contracts are being drawn up. A further important area of post-completion risk is that of the potential hazards to predictable and stable cash-flow arising from the physical operation of the project. Just as a banker will wish to ensure that the contractor employed to construct a project is competent and financially
705 sound he will also wish to satisfy himself that the operating team engaged to run the project is skilled in the employment of the relevant technology and able to deal with all foreseeable situations, whether they are routine or more particularly when they require additional inputs of skills and resources to maintain operation and cashflow generation. Banks often derive significant comfort from the employment by a project sponsor of a third-party operations and maintenance ("O&M") contractor, because of the deeper reserves of skills and personnel which this can make available to a project and because O&M costs can thereby be contractually fixed. Sponsors are well-advised to consider this option, even though it may involve greater expense, because of the additional "comfort factor" which it provides to lenders. Sponsors should also take great care to review the efficiency levels and downtimes / outages which are predicted in the cashflows they provide to banks. It is better to predict easily-achievable levels of efficiency and availability and refer to the higher levels which may be achieved than to strain the banker's credulity by presenting a base case with levels set at the high end of what can be achieved, even if the sponsor thinks that these targets can be met. Sponsors of renewable energy projects are generally well aware of the importance of the planning and environmental framework to which their projects must conform. In our experience however they do not always appreciate that potential lenders are increasingly concerned to protect themselves against the consequences of a project breaching official consents and guidelines, especially in the environmental field. It is already the case in the USA that lenders who take possession of their security when a project fails to perform may themselves be liable for the legal consequences of pollution caused by that project. The position is not so hard and fast in other countries, but bankers are concerned that the increasing trend towards environmental regulation at all levels of government - local, national and supranational - might increase the danger of bankers being forced to meet vast claims arising out of pollution caused by borrowers. It is essential therefore when approaching a potential lender to prepare and present full details of all consents and approvals of whatever kind - planning, environmental, generating licence, etc - which are expected to be required and the status of the efforts being made to obtain such consents. Evidence should also be provided of the ability of the proposed project to meet all present and likely future constraints and limits. Foreseeing what environmental and planning agencies might impose by way of constraints in the future is clearly not an easy task, but a banker being asked to rely on a project's cashflow for repayment over say a 7-year period will wish to assess and limit the risk of the project being closed down by environmental regulators when the debt raised to build it is only partly repaid. Banks will not necessarily require all consents and approvals to be in place before they will negotiate a financing structure, but sponsors should expect the granting of all necessary consents to be a "condition precedent" to be fulfilled before any loan funds can be drawn. A lender can only be repaid when a project is generating cash and therefore banks have an acute interest in all aspects of the "offtake" or sales risk. Only in rare cases will project lenders accept the "volume" risk - the danger that the output from a given project will not find a purchaser at all. Whether or not they will accept the risk of an acceptable price being achieved for the project's output will depend on the maturity of the market for such products and the volatility of prices in such markets. The availability of long-term, guaranteed-price power purchase contracts for renewable energy projects in some countries is a key element in substantially eliminating the volume and price risks from renewable energy projects. Some contracts may offer the banker an "offtaker" of undoubted financial standing and the ability to "lock in" output pricing over the life of the contract. Sponsors should expect lenders as a general rule to require the repayment of their loans during the life of any such preferential offtake contract or, if they are prepared to consider having a portion of the debt repaid after the volume and price risk have re-emerged, to take a very conservative view of likely price
706 trends. Sponsors should anticipate this attitude when preparing their case for potential project lenders and should also take into account that (as for fuel supply contracts) a project lender will almost certainly wish to take a security interest in power and heat sale contracts. Are the Economics of the Project Bankable?
Finally, we must address the question of the economic bankability of a project. To enable the lender to analyse whether the economics of the project are capable of supporting a particular loan value a computer model will be built to review the project from a banking perspective. The lender will then use this model to test the economics of the project and its sensitivity to changes in various parameters. The analysis will usually involve the construction of a financing model, as an "add-on" to the project economics. This paper cannot deal in detail with the economic analysis and loan structuring methods used by lenders but suffice it to say, the lender will review certain cover ratios relating cashflow generated to debt outstanding and will calculate the loan amount such that minimum cover ratios are met throughout the term of the loan. However robust a particular project's economics, the lender will still almost certainly require a minimum equity input from the project sponsor. The key banking cover ratios employed are likely to be: Annual Debt Service Cover Ratio (ADSCR): The annual cash flow divided by annual debt service repayments (principal and interest) (Note the definition of cash flow may vary, but the most common is revenue less cash operating expenses less tax paid). This ratio will be calculated for each year of he life of any loans contemplated and the values for each year - plus the trend over time - will give the banker an indication of the margin of safety offered to him by the projected project cashflows as compared with the payments projected to be due to him. In SML's experience this ratio would be calculated for almost all renewables projects by potential lenders. The formula for the calculation may be expressed as:
707
Cashflow before Debt Payments in a given year divided by Interest and Principal Repayments in that year Present Value Based Cover Ratios:
In addition to the ADSCR, bankers may also look at cover ratios which bring back to today's value the eashflows which will be received throughout the full life of the Project and/or over the term of any proposed loans. These eashflows are "discounted" to a present day value and this value is then compared with the projected amount of loans to be used to part-finance the construction of the project. The prime ratio is the Loan Life Cover Ratio, which compares the present value of cashflows during the remaining life of any loans with the remaining principal amount still to be repaid. As a very general rule bankers would normally expect to see 1.5 x cover of the amount of principal still outstanding. The Project Life Cover Ratio is calculated in the same way, but with the numerator of the equation being based on the cashflows still to be received throughout the remaining life of the Project (ie up to and beyond the scheduled final repayment date of the loan facilities). The difference between these two ratios tends to provide an indication of the extent to which the banker could extend the original life of his loan if necessary and still be confident of ultimate repayment. Loan Life Cover Ratio (LLCR): The present value (PV) of the cash flows after tax but before debt service (principal and interest payments) over the unelapsed life of the loan divided by the principal outstanding at the point in time that the ratio is being calculated (this ratio is calculated periodically throughout the loan). Given as a formula: Present Value of the Surplus Cashflows before Interest and Principal Payments over the remaining loan life divided by Principal Amount outstanding at the time the Ratio is calculated Project Life Cover Ratio (PLCR): The PV of the cash flows after tax but before debt service (principal and interest payments) over the unelapsed life of the project divided by the principal outstanding at the point in time that the ratio is being calculated (this ratio is also calculated periodically throughout the loan). Given as a formula: Present Value of Surplus Cashflows before Interest and Principal Payments over the remaining Project life
708
divided by Principal Amount outstanding at the time the Ratio is calculated If the lender decides the project is bankable he will then set about incorporating detailed conditions into the loan structure to protect his position. These provisions will usually involve the taking of formal security interests in the project assets and cashflows and the imposition of restrictive covenants. These covenants or restrictions may involve for example the maintenance of a reserve account by the project company for debt service purposes. It is common for the reserve account to build up to a pre-agrecd balance before any cash flow is released to the project sponsors. The subject of project loan security structures and covenants is a complex one and one in which SML has considerable experience, but it is not a topic this paper can deal with in detail. Conclusion
In conclusion we shall summarise the recommendations made in this paper about the way in which a lending institution will review a project F_'nancing transaction but first we would urge sponsors to consider employing professional advisers to assist in the process of raising debt finance. A debt adviser is able to advise potential borrowers on what is likely to be achievable, who best to approach and how the approach should be made. Companies often do not seem to be concerned at paying commissions to advisers raising equity but this is sometimes not regarded as necessary for debt raising. In our opinion, the raising of project finance warrants independent advice as most companies cannot justify employing an individual with the specific skills in this area on a full-time basis. To summarise our recommendations then. Firstly, do not ignore the banker's general concerns and motivations or approach lenders ill-prepared. Ensure you speak to appropriate banks and ensure a relationship is developed as early as possible with potential lenders. Develop the relationship with the right individual - introductions are much better than cold approaches. Give the lender time and keep him updated on developments up to the point when the bank is formally approached for finance. When the approach has to be made to the lender to request finance, once again 'Be Prepared'. Analyse the risks as a banker will, and try to mitigate or lay off risks which will clearly be unacceptable to the bank. Be conservative - do not ask the bank to assume risks which are not bankable. By offering the lender upfront a well thought-out and balanced package of risks and a reasonable risk-reward ratio the probability of achieving a successful financing will be greatly improved. We hope that this paper may be of help to those of you who are contemplating raising project financing. The present state of the banking markets does not make this task easy, especially for the smaller project. You will however maximise your prospects of raising finance if you approach the exercise in the right way.
Elsevier Science Ltd Printed in Great Britain 0960-1481/94 $7.00+0.00
Pergamon
PROJECT FINANCE FOR RENEWABLE ENERGY S J Mills, Director Sceptre Management Limited, UK and Melissa Taylor, Consultant ABSTRACT This paper is intended to provide general advice to sponsors of renewable energy projects who expect to raise project-based financing from commercial banks to fund the development of their projects. It will set out, for the benefit of such sponsors, how bankers typically approach the analysis of these undertakings and in particular the risk areas on which they concentrate. By doing so it should assist sponsors to maximise their prospects of raising bank finance. The watchword for sponsors approaching banks must be "Be Prepared". KEYWORDS Finance, Bankers, Risk Analysis, Annual Debt Service Cover Rario.
Before going further however we should define the term "project finance". Many definitions exist but what most lending bankers generally mean by the term is: 'the financing of a project or other asset or undertaking which is repaid principally from the cash flow generated by the project or asset being financed'
Typically the lending banker will have little or no recourse to any other assets or cashflows of the project sponsor. Hence the alternative descriptions - "limited- (or non-) recourse financing" or "off-balance-sheet financing". We should also ask why project sponsors may wish to use project finance for the financing of renewable energy developments. There are a number of different potential reasons. Firstly, isolating the project in this way may mean the corporate sponsor can avoid showing the debt on its balance sheet. Secondly, where corporate capital is limited and must be rationed among competing projects, limited-recourse project financing may provide a means of increasing the debt element of a project's funding. Assuming the project is successful this will have the effect of increasing the return on equity invested in the project. Thirdly, in a project invoMng more than one sponsor where a joint venture structure has to be adopted, project financing may be an attractive option. Where one party is financially stronger than its partner such a party may seek project finance for the whole project to ensure the weaker partner has access to sufficient funds for its share of costs. Fourthly, a sponsor may have the conscious aim of laying off or at least limiting specific risks. Last but certainly not least, for the smaller sponsor project financing may be the only source of finance available. This list is certainly not exhaustive, but it may help to clarify the typical motivations of project sponsors in seeking project financing. Needless to say the categories mentioned above are not exclusive either - a single sponsor may be pursuing several of the above objectives at the same time. Having defined our terms and understood the sponsor's likely reasons for seeking project financing we can now turn to the banker's attitude to this type of funding. When approached with a project financing opportunity the lender will usually seek to address three key areas: 700
701 'are the economics of the project bankable?' 'what are the project risks, are these risks acceptable and if not how can they be mitigated or allocated to acceptable third parties?' 'is it worth the effort to try to answer the first two questions and put together an acceptable deal structure?'
This last factor is of critical importance, especially for the smaller renewable energy entrepreneur seeking to arrange project finance for the first time. Winning the Banker's Attention
Because of the importance of the third question these three areas will be looked at in reverse order. Many projects never make it past the first discussion with potential lenders and, once a lender has said 'no', it is extremely difficult, if not imposs~le, to resurrect real interest. The reason for the lender turning down a particular deal may be justifiable. The project may not be viable from an economic perspective. However many potential sponsors may have met with comments from bankers such as: 'the sponsor is too small compared with the size of the project' 'the technology risk is unacceptable' as a first comment from a potential lender before he states that he does not wish to pursue the opportunity. The sponsor may feel that the lender has completed no more than a cursory review of the project and has not explored the ways in which such risks or problems could be mitigated or allocated to third parties. The sponsor may well be correct. In such circumstances one may never know how closely the potential lender has analysed the financing opportunity or indeed the real reasons why he is not interested in the proposal. The point is that the sponsor should "Be Prepared" by understanding the major factors which drive a banker's thinking and attitudes. We would like to draw out three separate issues which may influence a banker's views -especially in today's banking market - before he even undertakes a detailed evaluation of a potential renewable energy project. Firstly, it is useful for project sponsors to understand the current state of the world banking markets. Many banks have experienced major losses as a result of the Third World Debt Crisis and US secondary banking market problems, and more recently from the effects of the world recession on their clients. These events have resulted in a weakening of banks' capital ratios which -to complicate the problem further - have now to be maintained at minimum levels under the Basle Convention. The banks have two options if they are to maintain capital ratios either to raise more capital, which may not be a real option, or to reduce their asset bases by a reduction in lending. Project finance is a specialist, higher-risk area of banking often with large capital requirements. One result of the problems in the world banking markets has been a reduction in the number of banks willing to provide project finance. How can project sponsors react to such developments? First of all, they should target their approaches to those remaining project financing banks which have retained the lending capacity to support the capital-intensive industries. Secondly they should, wherever poss~le,
702
draw upon any existing relationships which they may have with banks and seek to capitalise upon them. In times of capital stringency banks will tend to support their existing clients, sometimes even to the detriment of sound projects proposed by non-customer sponsors. We shall have more to say about the banker's attitude to the identity and standing of project sponsors shortly. The second issue here is the failure of many sponsors to understand the fundamental approach a banker must take in terms of his "risk-reward" relationship with a project. The lender's recourse is limited to the Project's assets and cashflows. If it performs badly he may lose the whole of his principal, let alone the interest due to him. As such he may be said to have "maximum downside". If the project outperforms all expectations the lender can (usually) hope to do no better than to receive his principal back plus the agreed interest payments. Thus he has little or no "upside" potential. Given such a risk-reward balance a provider of bank finance will probably be most concerned to limit risla Although he may be indirectly interested in the Internal Rates of Return potentially available from the project he will be much more concerned to establish that the project will be able to service its debt, with a good margin of cover, under a wide range of adverse scenarios. Put in these terms the issue may seem obvious, but in our experience sponsors frequently fail to approach a potential lender with an information package which demonstrates an understanding of his likely concerns and attempts to address these concerns in a manner which makes his analysis easy to carry out. Meeting the lender on his own ground and satisfying him that he is not taking an undue measure of risk is a critical component of "Being Prepared". The third aspect of a banker's general attitude is the question of project size. Sponsors should be aware that the smaller the project and associated debt requirement the more difficult it is likely to be to raise finance. In today's market where the active project lenders are being asked to look at more projects, the earnings potential from a $100 million project loan will usually ensure that it takes precedence over a $10 million potential facility as they will both require broadly similar amounts of time to review, structure and document. Clearly if a sponsor has a $10 million project there is little he can do about its size, and this should not be taken as saying that smaller projects cannot be financed - project-based debt finance has been raised for projects costing less than $2 million. The point is, however, that a sponsor seeking finance for a smaller project should anticipate the "size" objection and should consider before approaching potential lenders whether he is prepared to offer the lender a level of return - eg by way of higher front-end fees - which though expensive from the sponsor's viewpoint does at least ensure that the project does not fall at the first financing "fence". Again - "Be Prepared". Risk
Analysis
and Allocation
Assuming that the sponsor has successfully negotiated the first hurdle and convinced the banker that a full analysis of the project should be undertaken, the next stage will usually be for the banker to carry out a review of the major risk areas of the project. These areas of risk vary from project to project but we will concentrate briefly on seven key areas of risk. T h e s e are; - Sponsor Risk - Technology Risk - Completion Risk - Input / Supply Risk - Operating Risk
703 Approvals / Environmental Risk Offtake / Sales Risk Sponsor and completion risks are closely associated as a lender's view on completion risk will be strongly influenced by his view on sponsor risk. Sponsor risk is extremely important and recent discussions with project lending banks suggest that it is becoming more rather than less important in the current market. Indeed one European bank recently commented that: 'our preliminary review of a project is increasingly sponsor-driven'. What then is meant by sponsor risk? Banks take an interest in the sponsor of a project on two levels. A lender will normally require a capital contribution of anything from 15%-50% of the project cost to ensure the sponsor's continued commitment. Banks are interested in project sponsors on another level however. Regardless of whether the lender is seeking pre-completion guarantees from the sponsor (which we shall discuss later) banks predictably like to work with corporate sponsors with substantial technical expertise and financial "depth". The 'backstop' value to a bank of a sponsor who can commit resources either financial or technical to turning around a problematic project is very great. Therefore entrepreneur sponsors of renewable energy projects - who will often not have the same corporate "substance" as major companies should anticipate and prepare for a discussion with potential lenders on this issue. The attitude of potential lenders towards sponsor risk is a key factor in steering many sponsors towards inviting a more substantial sponsor to enter into a joint venture arrangement. This will usually have the effect of reducing sponsor risk in the eyes of a potential lender. Smaller sponsors should not assume however that it will be a waste of time to approach bankers before the support of a more substantial partner has been negotiated. On the contrary - if the original sponsor is aware in detail of the type and extent of support the banker will require from the equity investor(s) in a project he will be in a much stronger position when negotiating the terms of any joint venture with a new partner. Moving on to completion risk, banks are willing in certain circumstances to assume precompletion risk for projects. By this we mean that they may be prepared for their lending to be limited in recourse to the project itself before completion occurs. Acceptance of precompletion risk is by no means the norm however. Often banks will require some kind of external recourse until completion, such as a guarantee from third parties such as the owners of a project-owning joint venture company. Entrepreneur sponsors in particular should therefore be prepared for lender concern on the issue of pre-completion risk as they will usually not be able to offer blanket guarantees of such risks which would be acceptable to the lender. It is an important component of being prepared that the sponsor should have analysed the pre-completion risk issues likely to be raised by potential debt providers and should be in a position to demonstrate: a)
that the pre-completion risks involved are modest, and/or
b)
that everything possible has been done to mitigate these risks and/or to lay them off elsewhere.
It is very important for sponsors to understand what is meant by 'financial completion' as opposed to 'physical completion' in terms of what risks sponsors may be asked to assume. For financial completion to be demonstrated, not only will the project facilities have to be acceptably completed but operation will have to be sustained at a pre-agreed level of output, with availability figures and operating costs also meeting pre-agreed targets over a specified
704 period. Essentially a sponsor providing a completion guarantee may well be assuming a number of other project risks. For example a project in production and operating satisfactorily may never achieve completion due to not achieving cost forecasts. The lender will focus upon the cost-overrun and time-delay aspects of the completion risk in great detail. This is the period of highest risk for the lender. The lender may face a total writeoff in respect of a project which never produces cash flow. The lender will seek to minimise this risk by looking at such aspects as whether high-value items can be built under fixed-price turnkey contracts. He will also analyse whether the various contractors are financially sound and whether their obligations are covered by performance bonds or third party sureties. It may be poss~le subject to the robustness of the project economics to pre-agree a debt-funded cost overrun contingency facility, or indeed to raise additional equity up-front. Banks can be expected to pay a great deal of attention to the question of technology risk in renewable energy projects. As we explained earlier, because of their risk-reward relationship with a project bankers are keen to limit risk and in particular they will always seek to avoid accepting risks which should properly be taken by the equity owners in the project. Any technology which is at the "leading edge" of current practice will certainly be placed in this category. As a technology becomes more established using other funding sources banks may become comfortable with the predictability of the processes involved and begin to accept the technology risk. Some banks have already completed this process for technologies such as wind turbines and landfill gas. Even for technologies such as these, however, project sponsors should be prepared for a detailed examination of the technology risk issue by potential debt-providers and should seek in their initial paper to demonstrate:
a) b) c) d) e)
that the technology has a satisfactory track-record; that the contractor building the project has experience of the technology; the adequacy of the guarantees / warranties which have been negotiated; the ease with which maintenance and, if necessary, component replacement can be carried out; that the availability / efficiency levels predicted can be easily achieved.
By input / supply risk is meant the risk relating to provision of the relevant source of energy to the project in question, such as methane-bearing gas in a landfill project, wind energy for a windfarm, chicken litter in a waste-burning power station and so on. Where there is a distinct (and finite) "reservoir" of fuel for a project - such as in a closed landfill - bankers will look for an independent corroboration of the sponsor's reserve figures by a first-class consultant appointed by the Bank and paid for by the sponsor. Given the risk-reward relationship the banker has with the project he will typically wish to concentrate on any "core" reserves which have the highest degree of certainty and to have his debt repaid well within the predicted economic life of these reserves. Even where there is no reserve factor to be considered project sponsors should, when approaching potential financiers, be prepared to demonstrate the security of fuel supply arrangements, including the basis of pricing of the fuel. The sponsor's presentation should show that the assumptions made relating to the quantities and pricing of fuel are conservative and that even on this basis the proposed debt can be retired with a significant margin of safety. It is likely that a lender will wish to take security over any fuel supply contracts and this factor should be borne in mind by sponsors when contracts are being drawn up. A further important area of post-completion risk is that of the potential hazards to predictable and stable cash-flow arising from the physical operation of the project. Just as a banker will wish to ensure that the contractor employed to construct a project is competent and financially
705 sound he will also wish to satisfy himself that the operating team engaged to run the project is skilled in the employment of the relevant technology and able to deal with all foreseeable situations, whether they are routine or more particularly when they require additional inputs of skills and resources to maintain operation and cashflow generation. Banks often derive significant comfort from the employment by a project sponsor of a third-party operations and maintenance ("O&M") contractor, because of the deeper reserves of skills and personnel which this can make available to a project and because O&M costs can thereby be contractually fixed. Sponsors are well-advised to consider this option, even though it may involve greater expense, because of the additional "comfort factor" which it provides to lenders. Sponsors should also take great care to review the efficiency levels and downtimes / outages which are predicted in the cashflows they provide to banks. It is better to predict easily-achievable levels of efficiency and availability and refer to the higher levels which may be achieved than to strain the banker's credulity by presenting a base case with levels set at the high end of what can be achieved, even if the sponsor thinks that these targets can be met. Sponsors of renewable energy projects are generally well aware of the importance of the planning and environmental framework to which their projects must conform. In our experience however they do not always appreciate that potential lenders are increasingly concerned to protect themselves against the consequences of a project breaching official consents and guidelines, especially in the environmental field. It is already the case in the USA that lenders who take possession of their security when a project fails to perform may themselves be liable for the legal consequences of pollution caused by that project. The position is not so hard and fast in other countries, but bankers are concerned that the increasing trend towards environmental regulation at all levels of government - local, national and supranational - might increase the danger of bankers being forced to meet vast claims arising out of pollution caused by borrowers. It is essential therefore when approaching a potential lender to prepare and present full details of all consents and approvals of whatever kind - planning, environmental, generating licence, etc - which are expected to be required and the status of the efforts being made to obtain such consents. Evidence should also be provided of the ability of the proposed project to meet all present and likely future constraints and limits. Foreseeing what environmental and planning agencies might impose by way of constraints in the future is clearly not an easy task, but a banker being asked to rely on a project's cashflow for repayment over say a 7-year period will wish to assess and limit the risk of the project being closed down by environmental regulators when the debt raised to build it is only partly repaid. Banks will not necessarily require all consents and approvals to be in place before they will negotiate a financing structure, but sponsors should expect the granting of all necessary consents to be a "condition precedent" to be fulfilled before any loan funds can be drawn. A lender can only be repaid when a project is generating cash and therefore banks have an acute interest in all aspects of the "offtake" or sales risk. Only in rare cases will project lenders accept the "volume" risk - the danger that the output from a given project will not find a purchaser at all. Whether or not they will accept the risk of an acceptable price being achieved for the project's output will depend on the maturity of the market for such products and the volatility of prices in such markets. The availability of long-term, guaranteed-price power purchase contracts for renewable energy projects in some countries is a key element in substantially eliminating the volume and price risks from renewable energy projects. Some contracts may offer the banker an "offtaker" of undoubted financial standing and the ability to "lock in" output pricing over the life of the contract. Sponsors should expect lenders as a general rule to require the repayment of their loans during the life of any such preferential offtake contract or, if they are prepared to consider having a portion of the debt repaid after the volume and price risk have re-emerged, to take a very conservative view of likely price
706 trends. Sponsors should anticipate this attitude when preparing their case for potential project lenders and should also take into account that (as for fuel supply contracts) a project lender will almost certainly wish to take a security interest in power and heat sale contracts. Are the Economics of the Project Bankable?
Finally, we must address the question of the economic bankability of a project. To enable the lender to analyse whether the economics of the project are capable of supporting a particular loan value a computer model will be built to review the project from a banking perspective. The lender will then use this model to test the economics of the project and its sensitivity to changes in various parameters. The analysis will usually involve the construction of a financing model, as an "add-on" to the project economics. This paper cannot deal in detail with the economic analysis and loan structuring methods used by lenders but suffice it to say, the lender will review certain cover ratios relating cashflow generated to debt outstanding and will calculate the loan amount such that minimum cover ratios are met throughout the term of the loan. However robust a particular project's economics, the lender will still almost certainly require a minimum equity input from the project sponsor. The key banking cover ratios employed are likely to be: Annual Debt Service Cover Ratio (ADSCR): The annual cash flow divided by annual debt service repayments (principal and interest) (Note the definition of cash flow may vary, but the most common is revenue less cash operating expenses less tax paid). This ratio will be calculated for each year of he life of any loans contemplated and the values for each year - plus the trend over time - will give the banker an indication of the margin of safety offered to him by the projected project cashflows as compared with the payments projected to be due to him. In SML's experience this ratio would be calculated for almost all renewables projects by potential lenders. The formula for the calculation may be expressed as:
707
Cashflow before Debt Payments in a given year divided by Interest and Principal Repayments in that year Present Value Based Cover Ratios:
In addition to the ADSCR, bankers may also look at cover ratios which bring back to today's value the eashflows which will be received throughout the full life of the Project and/or over the term of any proposed loans. These eashflows are "discounted" to a present day value and this value is then compared with the projected amount of loans to be used to part-finance the construction of the project. The prime ratio is the Loan Life Cover Ratio, which compares the present value of cashflows during the remaining life of any loans with the remaining principal amount still to be repaid. As a very general rule bankers would normally expect to see 1.5 x cover of the amount of principal still outstanding. The Project Life Cover Ratio is calculated in the same way, but with the numerator of the equation being based on the cashflows still to be received throughout the remaining life of the Project (ie up to and beyond the scheduled final repayment date of the loan facilities). The difference between these two ratios tends to provide an indication of the extent to which the banker could extend the original life of his loan if necessary and still be confident of ultimate repayment. Loan Life Cover Ratio (LLCR): The present value (PV) of the cash flows after tax but before debt service (principal and interest payments) over the unelapsed life of the loan divided by the principal outstanding at the point in time that the ratio is being calculated (this ratio is calculated periodically throughout the loan). Given as a formula: Present Value of the Surplus Cashflows before Interest and Principal Payments over the remaining loan life divided by Principal Amount outstanding at the time the Ratio is calculated Project Life Cover Ratio (PLCR): The PV of the cash flows after tax but before debt service (principal and interest payments) over the unelapsed life of the project divided by the principal outstanding at the point in time that the ratio is being calculated (this ratio is also calculated periodically throughout the loan). Given as a formula: Present Value of Surplus Cashflows before Interest and Principal Payments over the remaining Project life
708
divided by Principal Amount outstanding at the time the Ratio is calculated If the lender decides the project is bankable he will then set about incorporating detailed conditions into the loan structure to protect his position. These provisions will usually involve the taking of formal security interests in the project assets and cashflows and the imposition of restrictive covenants. These covenants or restrictions may involve for example the maintenance of a reserve account by the project company for debt service purposes. It is common for the reserve account to build up to a pre-agrecd balance before any cash flow is released to the project sponsors. The subject of project loan security structures and covenants is a complex one and one in which SML has considerable experience, but it is not a topic this paper can deal with in detail. Conclusion
In conclusion we shall summarise the recommendations made in this paper about the way in which a lending institution will review a project F_'nancing transaction but first we would urge sponsors to consider employing professional advisers to assist in the process of raising debt finance. A debt adviser is able to advise potential borrowers on what is likely to be achievable, who best to approach and how the approach should be made. Companies often do not seem to be concerned at paying commissions to advisers raising equity but this is sometimes not regarded as necessary for debt raising. In our opinion, the raising of project finance warrants independent advice as most companies cannot justify employing an individual with the specific skills in this area on a full-time basis. To summarise our recommendations then. Firstly, do not ignore the banker's general concerns and motivations or approach lenders ill-prepared. Ensure you speak to appropriate banks and ensure a relationship is developed as early as possible with potential lenders. Develop the relationship with the right individual - introductions are much better than cold approaches. Give the lender time and keep him updated on developments up to the point when the bank is formally approached for finance. When the approach has to be made to the lender to request finance, once again 'Be Prepared'. Analyse the risks as a banker will, and try to mitigate or lay off risks which will clearly be unacceptable to the bank. Be conservative - do not ask the bank to assume risks which are not bankable. By offering the lender upfront a well thought-out and balanced package of risks and a reasonable risk-reward ratio the probability of achieving a successful financing will be greatly improved. We hope that this paper may be of help to those of you who are contemplating raising project financing. The present state of the banking markets does not make this task easy, especially for the smaller project. You will however maximise your prospects of raising finance if you approach the exercise in the right way.